A place to exercise ideas before writing about them with greater discipline.

Wednesday, January 26, 2011

Purveyors of Noise

What happens when you assemble a panel of some of the world’s keenest analysts of economic signals before an audience too stupid to grasp the difference between signal and noise? This may be the best way to describe a panel assembled for the World Economic Forum in Davos on the topic of “the perils of economic prediction,” just reported on the BBC News Web site by Business Editor Tim Weber. I am familiar with the work of at least two of the invited panelists, Carmen Reinhart and Joe Stiglitz; and I know they are capable of explaining both the practices of what they can do and the supporting theory in language clear enough for a lay audience to understand. However, if the Davos audience wanted them to make predictions that would guide critical business decision making, than they may as well have been asking them to work miracles.

I suppose it all comes down to the fallacy of trying to use an explanatory model for predictive purposes. However, while there may be some validity to the hypothesis that knowledge of the past can prepare us to confront future situations, the very title of Reinhart’s book (This Time Is Different) stresses that the historical past that is most informative in an explanatory sense tends to be the evidence that is most ignored. The sad truth is that those Davos conferees are not interested in analysis. They just want magic bullets that increase wealth and power, and models to not provide those bullets.

At the risk of committing my own sin of over-simplification, I would suggest that, while figures of profit and loss figure in just about every economic model, economics is not about profit and loss, let alone, as the operations researchers would put it, maximizing profit and minimizing loss. Rather, economics is about how agents behave in the midst of complex systems, systems so complex that they involve a diversity of human actions far beyond the scope of the transactions of trade. This is why Alfred Schutz’ paper, “Common-Sense and Scientific Interpretation of Human Action,” includes a footnote mentioning that “A Treatise on Economics” is the subtitle of the book that Ludwig von Mises entitled Human Action. The panelists assembled to strut their stuff before the Davos audience probably all appreciate this distinction. They are probably also smart enough to know that those on audience side who invited them will most likely never get it.